Of Fuel and Fears

August 14, 2005

By Stanley Reed Why are oil prices topping records day after day? The simplest answer is that the markets have figured out that high prices aren't putting much of a brake on the global economy or crimping demand.

With China's annual growth in gross domestic product humming along at 9.5% and the U.S. economy robust, consumption of oil shows few signs of abating. Only Western Europe has been sluggish. "In the past couple of weeks, people's concern that the global economy is going to be harmed by high oil prices dissipated quite a lot," says Kevin Norrish, an analyst at Barclays Capital in London.

DAILY THREAT. Instead, traders and speculators have been piling into the market for crude and gasoline futures as they focus on a host of scenarios that could produce shortages in the face of relentless demand. Just about every day brings a new bogey -- from hurricanes in the Gulf of Mexico to al Qaeda gangs in Saudi Arabia.

The worry du jour is the overburdened U.S. refinery system, which has seen more than its share of outages in recent weeks. The latest, caused by a power interruption at Premcor's Memphis facility, lifted prices for the September NYMEX contract to a record $66.86 per barrel on Aug. 12. Traders are also looking ahead to the fourth quarter, when demands and prices are usually highest because of winter.

How high could prices go? In a recent report, Deutsche Bank calculates that the options market is now pricing in a one-in-three chance for prices to move above $75 per barrel before December.

FALSE ALARMS. Of course, prices could also drop. There are a lot of scenarios discounted at the moment. But it seems fair to say that a really major event, such as the strike by oil workers in Venezuela before the 2003 invasion of Iraq, could see oil powering up and additional $10 per barrel or more.

Some of the fears behind today's high prices are rational, and some aren't. It seems silly, for instance, for every bit of noise out of Saudi Arabia to send oil prices skyward, as happened this week when unspecified threats led to closings of the U.S. and other embassies in the kingdom. The long series of bombings and other atrocities in recent years by al Qaeda-type militants has failed to disrupt a drop of Saudi oil. Far from cutting back, the Saudis are actually spending billions of dollars to add some 2 million barrels per day to supply -- the equivalent of a large oil-producing country such as Kuwait.

Worries that the standoff between the West and Iran could somehow disrupt oil production also seem exaggerated. It now seems highly unlikely that the U.S., which has its hands full in neighboring Iraq, would take military action against the Islamic republic.

LITTLE TO SPARE. A more substantial concern is that the new government of President Mahmoud Ahmadinejad will purge Iran's Oil Ministry, a longtime target of Ahmadinejad's conservative allies, of political appointees and technocrats. While such a housecleaning might be a good thing, it could further hold up the award of contracts, reducing Iran's output over the long term.

The trouble is that with only minuscule spare capacity available in the world, every frisson in an oil producer looks to the markets like a dire threat -- or at least provides bullish traders with an excuse to buy. Total spare capacity, according to analysts, is at most 2 million bbl. per day in a world system now producing about 85 million bbl. per day. The situation is actually worse than it seems because pretty much all of that spare capacity is heavy, sour Middle Eastern crudes that refiners don't want -- which is why it's being left in the ground.

In such a taut system, every strain is felt. There have been unscheduled stoppages of production in the British and Norwegian North Sea fields this year. With weather forecasters predicting a nasty hurricane season, the markets worry about major outages in the Gulf of Mexico this summer and fall.

VAPORLOCK. Much the same is true of the refining side of the equation. With the U.S. refining system running at 95% or more of capacity, there has been a rash of partial shutdowns caused by explosions and other incidents at several U.S. refineries, including BP's accident-plagued facility at Texas City on the Gulf Coast and Sunoco's Philadelphia refinery.

Europe hasn't been immune. Royal Dutch Shell shut down its Pernis refinery in the Netherlands last month because of power problems, forcing it to look for gasoline supplies elsewhere, according to Washington-based consultants PFCenergy.

While substantial price corrections are possible -- even probable -- major fundamental relief doesn't appear to be on the way in next year or so. With no new greenfield refineries being built in the U.S., demand for gasoline and other products is likely to keep the system under pressure (see BW Online, 8/12/05, "The Prognosis for Pain at the Pumps").

The outlook for crude is also far from rosy from a consumer's point of view. The Paris-based International Energy Agency recently downgraded its 2006 production forecasts for Russia and Norway, two major producers that aren't members of OPEC. Disappointments there put the burden for taking up the slack on the Middle Eastern producers, which the market fears are politically unstable.

At the same time, most forecasters think demand growth will remain strong. The IEA, for instance, forecasts it at 1.78 million bbl. per day in 2006, following an increase of 1.6 million bbl. per day in 2005. Until an economic contraction puts a major dent in those numbers, it's hard to see today's prices falling very far. Reed is BusinessWeek's London bureau chief and Middle East correspondent